When you sell goods or services to a customer and allow it to pay you at a later date, this is known as selling on credit, and creates a liability for the customer to pay your business. Conversely, this creates an asset for your company, which is called accounts receivable. This is considered a short-term asset, since you are normally paid in less than one year.

An account receivable is documented through an invoice, which you are responsible for issuing to the customer through a billing procedure. The invoice describes the goods or services you have sold to the customer, the amount it owes you (including sales taxes and freight charges), and when it is supposed to pay you.

If you are operating under the cash basis of accounting, you only record transactions in your accounting records (which are then compiled into the financial statements) when cash is either paid or received. Since issuing an invoice does not involve any change in cash, there is no record of accounts receivable in your accounting records. Only when the customer pays you do you record a sale.

If you are operating under the more widely-used accrual basis of accounting, you record transactions irrespective of any changes in cash. This is the system under which you record an account receivable. In addition, there is a risk that the customer will not pay you. If so, you can either charge these losses to expense when they occur (known as the direct write-off method) or you can anticipate the amount of such losses and charge an estimated amount to expense (known as the allowance method). The latter method is preferred, because you are matching revenues with bad debt expenses in the same period (known as the matching principle).

We will illustrate these concepts below.

Recording Sales of Services on Credit

When you sell services to a customer, you normally create an invoice in your accounting software, which automatically creates an entry to credit the sales account and debit the accounts receivable account. When the customer later pays the invoice, you would debit the cash account and credit the accounts receivable account. For example, ABC International billings a customer for $10,000 in services, and records the following entry:

If you were to sell goods to a customer on credit, then not only would you have to record the sale and related account receivable (as was the case for the sale of services), but you would also record the reduction in inventory that was sold to the customer, which then appears in the cost of goods sold expense. This later transaction reduces the inventory asset in the balance sheet and increases the expenses in the income statement. For example, if ABC International were to conclude a sale transaction for $25,000 in which it sold $12,000 of merchandise to the customer, its journal entry would be:

Debit

Credit

Accounts receivable

25,000

Sales

25,000

Cost of goods sold

12,000

Inventory

12,000

There is an issue with the timing of the preceding sale transaction. If the sale is made under FOB shipping point terms, the seller is supposed to record both the sale transaction and related charge to cost of goods sold at the time when the shipment leaves its shipping dock. From that point onward, the delivery is technically the responsibility of either a third-party shipper or the buyer.

If the sale is made under FOB destination terms, then the seller is supposed to record these transactions when the shipment arrives at the customer; this is because the delivery is still the responsibility of the seller until it reaches the customer's location.

From a practical perspective, many companies record their sale transactions as though the delivery terms were FOB shipping point, because it is easy to verify. Recording the transaction upon arrival at the customer requires substantially more work to verify.

Accounting for Bad Debt

If you sell on credit, customers will occasionally be unable to pay, in which case you should charge the account receivable to expense as a bad debt. The best way to do so is to estimate the amount of bad debt that you think will eventually arise, and accrue an expense for it at the end of each reporting period. The debit is to the bad debt expense account, which causes an expense to appear in the income statement. The credit is to the allowance for bad debts account, which is a reserve account that appears in the balance sheet. Later, when a specific invoice is clearly identifiable as a bad debt, you eliminate the account receivable with a credit, and reduce the reserve with a debit.

For example, ABC International invoices $1 million of invoices to various customers in January and estimates that $40,000 of this amount will not be paid. Accordingly, it records the following entry to create a bad debt reserve:

Debit

Credit

Bad debt expense

40,000

Allowance for doubtful accounts

40,000

In March, ABC clearly identifies $18,000 of invoices that will not be paid. It uses the following entry to eliminate the invoices and draw down the reserve balance:

Debit

Credit

Allowance for doubtful accounts

18,000

Accounts receivable

18,000

If the customer were to later pay the invoice, ABC would simply reverse the entry, so that the allowance account is increased back to its former level.

An alternative method is the direct write-off method, where you only recognize a bad debt expense when you can identify a specific invoice that will not be paid. Under this approach, you debit the bad debt expense and credit accounts receivable (thereby avoiding the use of an allowance account). It is not the preferred method for recording bad debts, because it introduces a delay between the recognition of a sale and the recognition of any related bad debt expense (which violates the matching principle).

Accounting for Early Payment Discounts

If you offer customers a discount if they pay early and they take advantage of the offer, then they will pay an amount less than the invoice total. You need to eliminate this residual balance by charging it to the sales discounts account, which will appear in the income statement as a profit reduction.

For example, ABC International offers a $100 discount to a customer if it pays a $2,000 invoice within 10 days of the invoice date. The customer does so. ABC uses the following entry to record the transaction:

Debit

Credit

Cash

1,900

Sales discounts

100

Accounts receivable

2,000

The Accounts Receivable Aging

All outstanding accounts receivable are compiled into the accounts receivable aging report, which is typically structured to show invoices that are current, overdue by 0 to 30 days, by 31 to 60 days, 61 to 90 days, or 90+ days. This report is used to derive the allowance for bad debts, and is also a key tool of the collections department, which uses it to determine which invoices are sufficiently overdue to require follow-up action.

Accounts Receivable Reconciliation

The accounts receivable aging report itemizes all receivables in the accounting system, so its total should match the ending balance in the accounts receivable general ledger account. The accounting staff should reconcile the two as part of the period-end closing process. If there is a difference between the report total and the general ledger balance, the difference is likely to be a journal entry that was made against the general ledger account, instead of being recorded as a formal credit memo or debit memo that would appear in the aging report.